Sunday, May 31, 2009

California is sometimes known as the Golden Bear state. One thing about bears is that if you feed them they will keep coming back until you have no food, and then you are the food.

California is asking for a federal guarantee of their debt, because they are cash strapped and don't want to pay the extra money investors are demanding. As they face a 33% shortfall in revenues and expenditures, they have a lot of work to do. But never fear, in their words "California already has cut $15 billion and raised taxes by nearly $13 billion this year. Schwarzenegger has proposed cutting nearly $20 billion more, including eliminating California's welfare-to-work program and getting rid of health insurance for 930,000 poor children."That's funny. Their payroll keeps rising, so too total spending. The 'cuts' are hypothetical cuts from projections, sort of like when my wife saves us $50 by buying a pair of shoes yet foresaking a nicer pair.

The seeds of California's current crisis were planted more than 30 years ago, when voters overwhelmingly passed Proposition 13, a ballot measure that placed the state's budget in a straitjacket.

Even more important, however, Proposition 13 made it extremely hard to raise taxes, even in emergencies: no state tax rate may be increased without a two-thirds majority in both houses of the State Legislature.

A theory clearly 'too good to check'. State spending in the past two decades, as this Reason Foundation report spells out, has increased 5.37 percent a year (and nearly 7 percent for the past decade), compared to a population-plus-inflation growth rate of 4.38 percent. If the budget growth rate had been limited to the population-inflation growth rate, the state would be sitting on a $15 billion surplus right now. The California tax burden is not unambiguous because it comes from a variety of sources, making it multidimensional, but on almost all measures it is among the highest of the 50 states, in contrast to the theory proposed by Krugman.

Just as the investment frauds are not revealed in good times, bad governments are not exposed until recessions. And so too Nobel-prize winning economists.

Friday, May 29, 2009

Time magazine asks, What is the probability of rolling a pair of dice 154 times continuously at a craps table, without throwing a seven? Their answer: 1 in 1.56 trillion.

Patricia Demauro, a New Jersey grandmother,had a 154-roll lucky streak, which lasted four hours and 18 minutes, broke the world records for the longest craps roll and the most successive dice rolls without "sevening out."

But there's actually some path dependence, and a stat professor who really knows gambling estimated it as 1 in 5.3 billion.

So, 1 in a trillion, or billion. Both are beyond our intuition, but the extra 3 zeros matter.

That's the chart over the past week. GM stock trades at about 78 cents currently. Its bonds trade around 5 cents on the dollar. The UAW recognizes the problem, offering to no longer demand free dental and Viagra! I can't wait to see the Chevy Volt in 2010. Sounds like a decent golf cart.

Thursday, May 28, 2009

In April I wrote about what an 'idiot' Joe Stiglitz is, because he's always making the same point to justify a greater government control and I wanted to use the word 'idiot' prominently in a blog post. Luckily, I did not waste the appelation on an undeserving person or incident. Remember, Stiglitz believes that because of asymmetric information markets are not necessarily perfect, government is more efficient. If the latter part of the proof is not clear to you, join the club.

Stigtitz gives speeches every other day, literally, which really causes brain rot, because so often seeing people appreciate you repeating yourself, you forget that you are a prop, and your repeated argument is not new, convincing, or true. All they want is to make money off your brand name. Conferences need a draw, and you have name recognition they need you regardless of your wacky calls for a one-government solution to Global Warming via e-chips implanted in our shoulders. At lunch people will be talking about Kobe Bryant and Star Trek's latest movie, and the organizer will be happy that he had a good attendance.

Anyway, back on March 31 in the NYTimes Stiglitz used his laser-sharp mind to highlight that Geithner's then-latest bank plan was a massive give away to banks and the investors in the plan. The government was socializing losses and privatizing gains. His example suggested a 54% return to investors, a -40% return to government. If true, you would expect a stampede of investors.

The Wall Street Journal reports almost no one is interested. By revealed preference--a test made prominent by Stigtlitz's mentor Paul A. Samuelson--it's not a good deal for either banks or investors, so either he made a math error or had flawed assumptions. I noted at the time this was not a give away, primarily because government was a pari-passu partner, not mere senior debt, in the deal. With modest assumptions the leverage on mortgage pools did not generate sufficient convexity in the payoff to generate the massive return asymmetry he suggested. And more importantly, government has given many signals that any assistance implies a large, undefined amount of government ownership, from compensation caps to H1-B visa restrictions, overseas investment restrictions, and Elizabeth Warren.

I found a PR newswire from what appeared to be Stiglitz's ghostwriter on his website. It said:

Usually my strong opinions aren't falsifiable in any time period near when anyone remembers what I said, so this is a little uncomfortable for me. I was way wrong. I have to rethink my fundamental assumptions about the relative efficiency of government.

Markets fall short of perfection, but so does government. To point to market imperfections as proof of the need for government intervention is a naive fallacy, whereby we compare theoretical imperfect real markets to imaginary governmental institutions that lack the smallest imperfection, as if I would compare my 60-year old wife's imperfections to Beyonce's body combined with Amy Freed's wit. That's a rather irrelevant comparison, in retrospect.

Looking at the interweb, I used the google to find a vast literature exists on the imperfections of government in allocating resources. For instance, Detroit has been run from top-to-bottom by government-loving Democrats since the 1970's, and yet it still has lagged neighboring cities. Who knew?

Wednesday, May 27, 2009

I was drawn to Geoffrey Miller's book Spent because I like evolutionary psychology. He's a relatively funny guy, lumping together 'burglars, prostitutes, and babysitters' (all big tax avoiders), and other funny little ripostes. He goes over some obvious facts, like that female beauty basically corresponds to a woman trying to look like a woman in her peak fertility: smooth skin, pert breast, white sclera, shiny hair, rosy cheeks, hourglass figure, etc. As most people prefer intelligence in their mates, IQ is positively related to romantic attractiveness, which I'm sure is of cold comfort to those chess club members who are taking their cousin to the prom. Did you also know that IQ is positively correlated with brain size (in spite of SJ Gould's Mismeasure of Man), size of specific cortical areas, concentrations of particular neurochemicals, height, physical symmetry, and semen motility?

He's big on signaling, and in a series of experiments researchers found that people were more likely to expend money and effort on products and activities if they were first primed with photographs of the opposite sex or stories about dating. Men were more willing to splurge on designer sunglasses, expensive watches and European vacations, while women became more willing to do volunteer work and perform other acts of conspicuous charity — a signal of high conscientiousness and agreeableness, like demonstrating your concern for third world farmers by spending extra for Starbucks’s “fair trade” coffee. I don't know how that fits in with my private survey data documenting men like to sleep after sex while women want to talk, watch tv, or clean the house; if everything's a sex signal, it seems we are miscommunicating when the object of signaling is right there.

But he mentions that people have 5 traits other than intelligence that are genetic and the subject of signaling. These Big Five are

Conscientiousness - a tendency to show self-discipline and aim for achievement; planned rather than spontaneous behavior.

Extraversion - energy, positive emotions, and the tendency to seek >stimulation and the company of others.

Agreeableness - a tendency to be compassionate and cooperative rather than suspicious and antagonistic towards others.

Neuroticism - a tendency to experience unpleasant emotions easily, such as anger, anxiety, depression, or vulnerability.

These traits have a bell curve but unlike intelligence where having more is generally better than having less (some have suggested 130 is an optimal IQ because it allows greater empathy with more people), these traits are a lot more ambiguous. The barista whose face looks like a tackle box is seen as 'too open', and the guy who hates gay people is 'too closed', and so on for all the Big Five. Thus, he argues we spend a lot of time signaling our agreeableness or openness, say 115 on a 100 mean bell curve. But given people are randomly distributed in these traits, and more is not necessarily better, it seems that 100 would be 'optimal' from the sense of maximizing popularity, and in the logic of Spent, hooking up and passing on one's genome. That is, I bet you get laid more in college if you don't have a lot of conspicuous piercings, and don't brag about hating gay people.

His Theory of Everything is that we basically have evolved to signal too much on wasteful peacock displays, like Rolex watches, that waste resources and make poor people feel bad. Consumer drek such as that sold at the Mall of America he gives as a prime example of a consumer abomination. I live by the Mall of America. It has a mini amusement park open year round inside (good for Minnesota). I bought year passes for several years, and on many Sundays would take my kids there, they would run through several rides and play in their giant Lego park. We would get some ice cream, I would visit the bookstore, shop at fun stores like Brookstone. Who knew our happiness was actually a false consciousness?

His cure? A consumption tax. I have no problem with that, replacing an income tax with a consumption tax. But then he adds two insanely scary nuances. First, keeping track of consumption so we can make it progressive. If everything has a 30% VAT, then rich guys pay 30% just like poor guys. That is not progressive. Every purchase would need to be recorded at some Department of Consumer Purchases, so government would know everything you have ever bought. That should end well.

Then, he wants to tax some things more than others, like cigarettes, luxury goods, and anything that has an externality. The idea of externalities is highly intuitive; it makes sense that the actions of one affect the happiness of others. A positive externality occurs when one's actions benefit people who were not directly involved in exchange. Think of the benefit we get seeing a neighbor's well-kept yard that contains wild flowers and bunnies (awe). On the other hand, a negative externality imposes a cost on third parties. A factory polluting your streams creating three-eyed monster frogs would be an example. So, subsidize the positive externalities, tax the negative externalities, and social welfare is optimized. For a psychologist, this seems relatively straightforward.

Thus, he starts out by giving what he thinks is a no-brainer: taxing bullets. As bullets kill people, every bullet has an 0.0003% chance of killing someone (10billion rounds sold each year, 30k homicides). As the value of a human life is about $3MM, each bullet should be taxed at 0.0003%*$3MM, or $9. QED. As bullets cost about $0.22, that's a 4000% tax. He concedes there might be some offsets, skeptically noting crime prevention, but such a principled case needs to be made with proof, noting the "social, economic, medical, and funeral costs."

The idea that lawful bullet sales cause crime is fanciful. How many gun deaths are from registered gun owners? Very very few. DC basically outlawed guns and has a very high homicide rate, while rural areas have much greater proportion of bullet buyers and lower murder rates. Japan outlaws guns, in Switzerland everyone has one, both have low crime, so that's a null effect. But those are just a few facts, and so aren't definitive. It would be hard to reject the hypothesis that the social, economic, medical, and funeral costs are not some some small fraction of some really large number, especially when he is asserting a 0.0003% probability of causing deaths--standard errors probably asymptote above that. It is very hard to disprove things with very complex interactions, as for example you can't simply say unions are good because unions pay more because this higher wage comes only at the expense of rationing employment in that industry or firm, and ethanol means we don't burn oil, but we need a lot of energy to create this. Adding up the assets and liabilities is nontrivial. The key in these debates is to be the null hypothesis (ie, the statement to be refuted), because it's a lot easier to have proposition "A" be not rejected than rejected. Miller presumes his Liberal agenda would form all the null hypotheses, so we would tax frappuccinos, popular art, and fraternities, and subsidize almond croissants, Tori Amos concerts, and ergonomic keyboards.

It's fun to see a neat bunch of insights and powerful evolutionary theory all basically rationalizing the standard Liberal agenda. Didn't Cicero say the function of wisdom is to find the good? If the good is simply what Air America spouts all day, his signaling Theory of Everything seems a needlessly circuitous way to get there. Why not say we must subordinate everything to egalitarianism? Proof: Evolution. And if you don't believe in evolution, you must merely be a creationist fool. QED. But evolution explains a lot, not everything, about life, and there are many smart people who think opposite policies maximize long-run species fecundity. I don't think a top-down shift in social tactics via 'progressive' consumption taxes and subsidies is necessarily better for our 2-3 billion year future in this solar system. His vision is just an excessively intrusive nanny state trying to tell everyone what to do because consumers are so stupid, unlike wise, selfless politicians and bureaucrats.

Saturday, May 23, 2009

Kate Kelly, a youthful WSJ reporter, has this little scene in her book Street Fighters (p. 169):

[Warren] Buffet almost had to chuckle. It was sort of like having a woman standing in front of you who had taken half her clothes off and then asked whether she should continue, he thought. Just as he'd want the woman to finish the job, he was certainly curious to hear what was happening that weekend with the embattled Bear.

I read this and thought, what does a woman know about how a man feels when in the presence of a naked willing woman? In one sense it is obvious, in another, complicated. As female and male parts are complementary, their desires are probably similar at one level, opposite in another. If women wanted exactly what a male wanted, she would not want a male. But then, I though if she framed the hypothetical as what a woman feels in the presence of a naked man to generate implications, this would generate questions about her personal preferences she would rather avoid.

Friday, May 22, 2009

Recently congress passed a law limiting the ability of credit card companies to rates their rates. Often, as accounts got riskier by going past due, the companies would increase the interest rate. Companies complained this was rational risk pricing. The government said it's gouging, taking advantage of people down on their luck.

Today the FDIC announced it is raising the cost of deposit insurance. Again. As more banks fail, the FDIC needs more money to cover this cost. They already raised rates in January when banks were starting to show they were in trouble. Obama recently stated that "If a credit card company wants to raise interest rates, then that new, higher rate should apply to the debt you add going forward, not what you already owe." So, is the FDIC going to apply this only to new deposits?

Note also that the TARP is giving money to banks and charging interest on the money, in order to shore up bank capital. So, the government has one group putting money in, another taking money out. Different objectives, same tactic, opposite sign. Why not have the TARP give the money to the FDIC?

All politicians are narcissistic, I suppose. Who else wants to stand up in front of people, sense their opinion, and repeat it back to them as it were your own. The benefits of having all those eyes on you must be very large for such people. When Obama was 35, he wrote a memoir, as if being head of Harvard Law Review is something that makes your childhood really interesting to a wide audience. That's chutzpah. Now as president, he says "I" a lot.

I don't want to run auto companies. I don't want to run banks. I've got two wars I've got to run already. I've got more than enough to do.

From yesterday's speech on torture:

As commander in chief, I see the intelligence. I bear the responsibility for keeping this country safe.

It's not about you, Barry. You don't run the car company, or the war, so don't act as if you do. You don't 'see' the intelligence, it is filter for you by like-minded people in your administration. You are their chief spokesman, but don't kid yourself that you are micromanaging things. They hated Bush for saying "I'm the decider", so it goes both ways.

In the 1990's when I was speaking once on something I was doing at a company, a colleague pulled me aside and said, "that was great, but don't use 'I' so much, it's we." My initial reaction was: "player hater!" I did some neat things, had neat ideas. They were mine. But over time I learned he was exactly right. In any large organization where you are selling something connected to a brand, it's not about just you, you are part of a team, and need them more than they need you. Humility is a very useful virtue. Of course, you don't want the humility of slaves, or timidity, and anything great takes a little chutzpah.

Moderation in all things, including the opposites humility and pride. This starts with not using the "I" word when talking about national policy.

Wednesday, May 20, 2009

Several bloggers have posted on Hyman Minsky, who is somewhat of a celebrity now that a crisis happened, and he wrote about financial crises. I was a teaching assistant for Minsky in college, back in 1986 at Washington University in St.Louis. I probably would not have gotten an econ PhD without his motivation, I really admired his intellectual enthusiasm, that he was attacking problems of importance and getting a lot of meaning out of it. The essence of his theory is that markets are endogenously unstable, and so, left to their own devices they repeatedly crash and burn. That, I think is true. But his mechanism was rather vague. He posited you have normal (hedge) finance, where investment is inspired by cashflow returns, which pays back both principle and interest. In hedge speculative finance, returns merely cover the interest. Finally, returns do not cover interest or principle, and you are hoping for your collateral to rise in value, which can happen in a bubble.

Unfortunately, this theory is pretty useless in real time. If you look at leverage ratios over the business cycle, they don't vary too much, so empirically you can't look at leverage and see any pattern. Like now, it is all ex post, in that very few people were warning of a housing bubble pre-2007. After the fact it is obvious, but theory should be predictive. By definition, an asset collapse will be found to have been dependent on expectations of rising collateral prices, because if cash flow could prevent the crash there would not be one. On the other hand, some lenders knew their underwriting standards were predicated on collateral at least not falling in value, and this should have been a warning.

His post-Keynesian focus on the distinction between risk and uncertainty does not generate much insight, though I spent a lot of time on this because it is so very seductive. Though many have been intrigued by the Keynesian/Knightian uncertainty approach, in general uncertainty is positive correlated with volatility, and it does not generate a consistent return premium as one would expect. Analyst disagreement, trading volume, are correlated with volatility, and generally negatively related to cross sectional returns. IPOs have a lot of uncertainty--they have no track record--but they have lower than average returns. So I don't think this distinction buys one much, as risk and uncertainty are highly correlated, and so we have the same puzzles.

He had lots of wacky liberal ideas about economics. He thought monetarists were ideologues, that microeconomics was all apologetics (hated the 1st and 2nd welfare theorems), and that national income accounting implied deficits put a floor on profits (profits=investment+budget deficit). I remember once Rik Hafer was presenting some results on how rational expectations proved the Quantity Theory, noting that when money supply numbers were released, interest rates moved in the right way within minutes (in the eighties, money supply numbers moved markets--good times, good times). Minsky was reading the paper and said "you are doing all this over a 5 basis point move in interest rates! This is irrelevant!" And stormed out. Everyone kind of looked at each other like "there he goes again".

I remember a couple times when he heard the market was down a lot, he would get all excited. This is it! He was always waiting for the market to crash any second. After I got out of school, my first job was as an economics analyst for First Interstate Bancorp, and the fed was defending the dollar then, which in Minsky theory kills the Ponzi bubble. I had about $5000, and opened up an account at Charles Schwab. Based on my re-readings of Minsky, which made me always ready for a crash, I bought an S&P100 put on October 16, 1987 for $7, and sold it late on October 19 for $103 (no lie, see here). I was ecstatic, and Minsky loved it, as he was the motivation for anticipating the greatest one-day decline in market history. As the Fed eased, I then reversed the position, going long options in 1988. After taxes and naive execution of single stock options (option market makers were crooks back then), I got creamed, and even though I was long calls through 1988 when the market was up 22%, I basically was back to where I started (though with a really cool stereo) by the end of 1988. My arithmetic return was still astronomical, however.

The UAW is set to receive a 55% stake in Chrysler through its union trust fund once that automaker emerges from bankruptcy. The trust fund will also likely get up to 38% of GM's stock as part of its reorganization.

But that doesn't mean the union will be calling the shots at either company. In fact, UAW president Ron Gettelfinger said the union hopes to sell its stake in both companies quickly because he is more interested in raising cash to cover retiree health care costs than having an ownership stake in GM (GM, Fortune 500) and Chrysler.

"Let somebody else take the stock. Give us the money," Gettelfinger said at a recent press conference. "We are trading debt for equity, and what is the value of the equity? Let's be honest, it's zero today."

So, they have an offer for large blocks of stock they think are worth zero. As they are the union that dominates the cost structure at those companies, they can make it happen. Takers?

A TV reporter in Denmark wanted to prove the danger of shampoo. She said some hair-care products contain toxic chemicals. So she poured them into a fish tank. A dozen guppies proved her point by dying in front of the TV cameras. A veterinarian turned her in for animal cruelty. The reporter has been convicted in the incident from 2004. But the trial took so long, the judge decided not to punish her.

Awkward. I'm probably on Most Wanted posters in Denmark, given my experience with aquariums, and fishing (aka, fish torture).

Monday, May 18, 2009

This financial crisis has had two legs: the initial boom and bust in housing prices, primarily in the USA, and the accelerator mechanism that then turned this crisis into a panic, affecting financial institutions almost indiscriminately, and countries furthest away from the USA were among the worst performers. I think the boom and bust in the housing market was an amalgam of forces encouraging lower mortgage lending standards under the assumption that a disparate origination statistics by race can only be the result of arbitrary if not racist underwriting standards. As national housing price indices have never fallen year-over-year there seemed little risk to going with the flow, and besides, how often does the government and those affiliated with it (regulators) encourage greater risk taking? This is the Stan Liebowitz narrative. The government keeps meticulous data on loan originations by race to satisfy the Home Mortgage Disclosure Act, but conveniently does not keep track of default rates by these same categories (see here). After all, you don't want to give lenders an ability to defend their unconscionable redlining.

But until today, I was totally befuddled by the transmission mechanism, the amplifier. I mentioned that last year at this time I was at an NBER conference, and Markus Brunnemeier pointed out that the decline in housing prices was insignificant relative to the change in stock market, and this was in May 2008! Almost everyone in the audience of esteemed financial researchers agreed, and thought the market was in a curious overreaction. That is, we did not know why a loss of $X in housing valuation, caused a $10X change in the stock market--and it was only to get much worse. You see, greed, hubris, fat tails, copulas, regulatory arbitrage, do not really work. Merton's explanation that as equity prices fall, both equity values and volatility increase, presumes the equity value fall that needs explaining (after all, it is much greater than the value of the housing price fall).

Gary Gorton makes the first really compelling explanation I have seen, and he's an economist. He is drawing on his experience as a consultant at AIG, and his experience modeling bank runs. I think this highlights that those best able to fix things should not have totally clean hands. Banks are complex institutions that have a lot of very particular attributes to their balance sheets and cash flows, and while a physicist or non-economist would be untainted by failure to foresee the crisis, this also neglects the steep learning curve they would also face. It is easier to correct experts than create them anew, groups are rarely incorrigible when it comes to big mistakes everyone sees as such (in contrast, to say a post-modern literary theorist, whose failures are less concrete). Gorton did not anticipate the 2008 events, but his analysis is much richer than those blaming complexity or hubris (Merton did a nice job of noting that ABS are actually much less complex than your average equity security given that it is a residual to a firm with lots of discretion).

The Gorton story is as follows. We have not had a true bank run since the Great Depression in the US, so we forgot what they look like. The essence of a bank run is described in those books on Bear Stearns: sparked by plausible speculation and a first mover, if you think a bank is losing other depositors, it pays to take out your deposits, and as no bank is sufficiently liquid to pay off all its depositors immediately, if this idea become popular the bank is doomed as each depositor seeks its own self-interest in getting to be first in line for their money.

In the old system, retail customers like widows and families would put their cash in a bank. These depositors have then assets that can be used for transactional purposes, as they can write a check, and have the money wired out in a matter of days. Yet, the money brought in can be lent by bank, and using the law of large numbers, the bank can estimate their daily cash needs, keep a sufficient amount of reserves, and everything is kosher (this creates a money multiplier). Today, financial institutions are highly dependent on wholesale depositors. These are institutions like hedge funds and instead of depositing money in a bank, they deposit Treasuries, and more frequently, AAA rated securities (often derivatives, like AAA rated mortgage-backed securities). These depositor have overnight repo returns that can be used for transactional purposes because they can be turned to cash in a day's notice, but just like the retail story with actual cash, the AAA bonds the wholesale depositors leave can be lent (rehypothecated) by the bank as well. Retail cash has been in some large part been replaced by AAA debt.

Thus AAA rated bonds become cash used as deposits, and as AAA rated Asset Backed Securities had higher yields, but similar treatment to Treasuries, they gained more and more popularity. A key to these AAA rated bonds is that their default rates are, basically, zero. That is, at Moody's we estimated them at 0.01% annually. One should expect to see one or two of these securities default in one's working life (there are many of them, so you don't have to wait 10,000 years). They are informationally insensitive, because they have so much safety in them, going over their risks is pointless, uninteresting. That is, as these things have reams of data that show zero default rates, and the market thinks they have almost zero default rate, it was counterproductive to get worked up about their future default rates. You would have wasted a career crying wolf about AAA-rated securities from 1940-2005.

A systemic shock to the financial system is an event thtat causes such debt to become informationally sensitive, in this case, the shock to housing prices. But when these assets become stressed, everyone is understandably perplexed. It's as if the electricity stops working, an event no one really contemplated, and it is too late for everyone to become an electrician. What were previously information insensitive becomes really complicated when one actually works through the details of derivative that were previously assumed to have a 0.01% annualized default rate. This is necessary bayesian updating suggests that when you have several AAA rated defaults, the probability is that your model is incorrect, as opposed to just having bad luck, and you have to first figure out what that model is, and where it broke down (ie, is it just the housing price assumption, or a general fault with asset backed securities?).

This is consistent with bank panics pre-1933 in the USA. Historically, the public becomes wary of all bank deposits, and the bank's balance sheets go from informationally insensitive to sensitive, unmasking their complexity. Nonetheless, the actual number of bank failures in these crises was comparatively low (excluding the Great Depression).

Say the banking system has assets of $100 financed by equity capital of $10, long-term debt of $40, and short term financing in the form of repo of $50. In the panic, repo haircuts rise to 20 percent as banks are wary of previously Gold AAA rated securities, amounting to a withdrawl of $10, so the system has to either shrink, borrow, or get an equity injection to make up for this. As we saw, after some early equity injections during the fall of 2007, this source dried up, as did the possibility of borrowing. That leaves asset sales. So the system as a whole needs to sell $10 of assets. They sell their tradeable securities as their liabilities decrease, and those securities are in a pricing matrix with the AAA rated collateral that is increasing its haircut. Gorton estimates the banking system needed to replace about $2 trillion of financing when the repo market haircuts rose. This is the amplifier.

The increase in haircuts on repos basically removed liabilities from the banking system, and the prices fell on many comparable securities as banks shed assets. In the fire sale, assets are now worth $80; equity is wiped out. The system is insolvent at current market price levels.

How do we know depositors were confused about which banks were at risk? The evidence is that non-subprime related asset classes like auto loans, credit cards, and emerging market debt saw their spreads rise significantly only when the interbank market started to breakdown.

Thus, the problem is that repo replaced retail deposits as the center of the bank run, as AAA rated securities of all types used in these transactions were all downgraded implicitly to non-prime (below A2/P2), and in many cases based on mortgages which historically were the safest asset class in the US. There was a bank run but it was by the 'shadow bank sector', and so all we could see were the effects not the usual cause (lines of panicked individual depositors).

His suggestion is that we set up groups to oversee those AAA securities used in repo transactions, and perhaps put a government guarantee on them. Clearly, this would have solved the 2008 crisis, but as always one needs to be looking forward. I doubt AAA security repo rate rises will be the epicenter of the next crisis, so I really don't think that is any more useful than noting one should not buy loans extended to homebuyers with teaser rates and no money down.

Looked at in this narrative I marvel at how the future can be so like the past, but different enough to escape notice in real time. I suppose every war or financial crisis is like that.

Sunday, May 17, 2009

When Bear Stearns failed in May 2008, it basically went from trading at $60 on Thursday, $30 on Friday, and then they announced a $2 takeover price on Sunday. It was adjusted to $5 by Monday, and finally to $10 the following week. Quite the fall from $178 in January 2007.

What happened? Three books have been released that cover this debacle. Street Fighters by Wall Street Journal reporter Kate Kelly, Bear Trap by Bear Managing Director Bill Bamber, and House of Cards by William Cohan. Street Fighters is the easiest read, in that you could knock it off on a long flight, and reads with the simplicity of the newspaper articles from which it was derived. Bamber's insider account is interesting, but I get the sense that I'm missing out of both the bigger picture or what the main agents--the CEO's, the Fed--are doing. My neighbor used to work for AIG, and I can attest that he was as surprised as anyone by what happened and was buying stock the whole way down. If you aren't in the right place, your insider account is often rather barren. Cohan's book is probably the most definitive. So, I would say if you are really interested in this and have a lot of time, read Cohan's book. If you want to knock it off relatively quickly, read Kelly's.

These books highlight that banks really are different than other companies. The actual value of Bear is never really addressed. That is, are the assets worth more than the liabilities? This would get into details about the nature of the mortgages and other assets on Bears books. No one really goes into much detail here. As this was the key question, I was rather surprised that Bear did not have a standard template for explaining why they thought their mortgage assets--with a book value of $46B--were really worth that much. In the final hours, outside firms really had no way to value these assets with much confidence. Bear should have been able to slice a book sixteen different ways, by the vintage, FICO, LTV, and other dimensions of the collateral, look at how various securities are in the waterfall of the tranches. They should have had clear reference securities for benchmarking their valuation. For this reason, I don't really feel sorry for Bear. This was a major managerial failure.

In the summer of 2007, two of their hedge funds collapsed, going from being up a few percent, to being wiped out in merely a month. They had write downs throughout 2007 related to mortgage securities, and people were wondering if that was just the beginning. The week prior to Bear's demise, Renaissance, the huge hedge fund, pulled its money from its prime brokerage at Bear, and a large hedge fund can't do this without everyone knowing about it. Then, on Wednesday Goldman decided it did not accept Bear as a counterparty on some derivatives, and this was mentioned in an interview by Marc Faber on CNBC with CEO Alan Schwartz. While Goldman reversed their position the following day, this decision exacerbated the run as most hedge funds were pulling their money out of their Bear prime brokerage accounts. Why Goldman and Renaissance did this is really the big question that none of the books address, and given the importance of this event in the destruction of Bear, I imagine that is a story that will never be told because of legal liability. That is, if you say too much, a lawyer could argue the actions were damaging and contained bad faith bargaining, In any case once the run started the whole solvency question was rather moot, because if everyone is concerned that others are not rolling their debt over, they won't roll over Bear's debt, create a self-fulfilling prophesy. If Bear has 50 counterparties, but each thinks they other's are pulling their money out, then Bear will go bankrupt irrespective of its solvency. This is the nature of a bank run. Once it starts, it is very hard to stop. FDIC insurance stops most retail runs, but for banks dependent on short term financing, runs remain [see this paper by Gary Gorton, an economist who consulted for AIG on their derivatives exposure, and thus is very well informed, thinks the run by hedge funds really defined our current credit crisis.]

The thing about short term money is that one's credit quality has to be beyond question. Moving to BBB in your debt rating is basically a death sentence for such a firm, and a BBB rated company has only a 0.15% probability of default, so as a practical matter it is very difficult to say whether a company should be rated A (0.07% annualized default rate) or BBB. So, it's very tricky, which is why there is all this concern about trust, and keeping out of the gossip pages. You want bankers who are squeaky clean, and the pot-smoking rumors about 72 year-old ex-CEO Jimmy Cayne surely didn't help, though personally I don't see the relevance.

An interesting note in this debacle was the absence of the Risk Managers. They aren't mentioned at all various scenes because they really didn't matter. In that way, they are like Merton and Scholes in the LTCM failure--irrelevant. Those making the key decisions, making the key arguments, were the simple business managers: Alan Schwartz, a broker by training, head of Fixed Income Warren Spector, the Treasurer Bob Upton, and CFO Sam Molinaro. Indeed, Kelly writes "managers in places like risk management and operations were considered less important to the firm's core franchise and therefore largely excluded from important decisions." Risk Management lumped with operations. Ouch.

An interesting point is to what degree the hedge funds really drove this. If all the hedge funds were pulling their prime brokerage accounts, this could have driven the bankruptcy by itself. As hedge funds are greedy little companies like any other, the implications of their actions would clearly suggest that hedging their risk, or profiting from their predicament, would be a good trade. Thus, selling Bear stock and buying default protection on Bear, would drive down Bear's credit rating, exacerbating their problem, making more money for the hedge funds all the way down. For a big hedge fund like Renaissance, they must have know the implications of their actions, and it clearly suggested shorting Bear as a strategy. Some funds, like Citadel, seemed ready to step in and buy Bear, but as there were rumors of a bear run by hedge funds this was basically never considered by Bear, and only JPMorgan, custodian for Bear's assets, had the wherewithal to quickly review Bear's assets in time to generate a buyout bid.

Saturday, May 16, 2009

So, an economics reporter for the New York Times, who makes over $120k per year (120 plus overtime, whatever that is), couldn't pay his $4,700 per month mortgage. He wrote a book about his situation. He stopped paying his mortgage 8 months ago, and just sits in his house, waiting for the bank to kick him out. He does not mention it, but I imagine if the banks try to kick him out he will fight it, even though he is basically living there without paying anyone. He truly has no shame, as this is the center point of his New York Times Magazine article and his book.

He can't afford his mortgage, but instead of moving into a smaller place in a worse neighborhood, but he has chosen to stay in his current house without paying. He does not value the bourgeois virtue of paying one's debts. Legally, he can default on his mortgage, but extra-legally, he is a shmendrik (aka, loser).

I think he is a thoughtful person, probably a good neighbor and friend. But that he could rationalize this kind of unethical behavior highlights a big problem we all face. If the zeitgeist says that those who don't pay their mortgage, for whatever reason, are victims of big, greedy banks, then we have a big problem. It has always been proposed that a jubilee, or absolving debtors of their obligations, would fix problems, but doing this just raises the costs of debt for future borrowers, most of whom had nothing to do with the prior situation. You can't break promises without considering their effect on future transactions.

Thursday, May 14, 2009

Some conservatives and libertarians think that an Obama overreach will merely generate a backlash to an economy with less government. I'm not so sanguine. After all, the monopoly government has over education has never increased support for vouchers, rather, calls for increased funding to the same people that are screwing it up. Unlike business failures, which are abandoned, government failures merely ask for more money. A great take on this tendency is this podcast with Duke University's Mike Munger about Santiago's bus system. What was once a private decentralized system with differing levels of quality and price was been transformed into a system of uniform quality designed from the top down. The private system had problems, as sometimes drivers would drive too fast to get passengers (in a race), but they made money. The new system does not make money. Instead of paying drivers by the number of customers they pick up, they pay them by the time they keep, so if they are late they don't stop for passengers. The commute times went way up, and the diversity of services--express buses for rich people, simpler buses for lower fares--went way down. Everyone gets the same service now. The result is quite ugly but there is no going back, politically it is very difficult to undo a nationalization.

The scenario is very much like what I hear in modern public transit debates, where the thought that there are premium services, or services that skip the inner city, are taboo. So rich people don't ride. Anything that does not discriminate becomes crap. The smart or rich ones see they are subsidizing the others, leaving only the poor and stupid as your customers, being served by a non-profit maximizing entity. The result is classic public service: public golf courses, public schools, public rest rooms--the contrast with 'private' is night and day.

The new initiatives that are part of a stimulus package are permanent increases in the size of government, GS-14s with lots of rights until they retire, but little initiative, imagination, or incentives to get any. Oh well. I'm glad I wasn't born in Haiti, or in AD 1300.

Wednesday, May 13, 2009

Obama's personal finances suggest he was a typical subprime borrower, counting on some unknown good fortune to bail him out. In an excellent bit of sleuthing, Richard Henry Lee does the math.

In April 1999, they purchased a Chicago condo and obtained a mortgage for $159,250. Michelle had a 4-times a week visit from a personal trainer, shoes, piano lessons and private school for the kids, other expenses consistent with the lifestyle to which they had become accustomed (they were both Harvard Law grads, after all). The Obamas' adjusted gross income averaged $257,000 from 2000 to 2004. Yet tax returns for 2004 reveal $14,395 in mortgage deductions. This implies they owed about $240,000 on a home they purchased for $159,250 in 1999, which means they spent about $80,000 beyond their income from 1999 to 2004. Then Obama's book sales soared and Michelle explained, "It was like Jack and his magic beans."

Luckily for Michelle, speaker fees for ex-Presidents means they will never have to curb their excesses. But when he speaks of prudence or living within a budget, he is not speaking from experience.

Tuesday, May 12, 2009

Ethanol is a popular biolfuel because it is the main crop of Iowa, the key primary state in presidential politics. A big debate is whether the energy used to grow the corn and then process it, is greater than the amount of fuel produced. David Pimentel of Cornell states that ethanol from corn in the US needs 25,000 kcals of energy to create 19,400 kcals of energy, for a net cost of 29% in BTUs (it takes 1.29 BTUs to generate 1 BTU of ethanol). In contrast, Bruce Dale of Michigan State stated this metric was irrelevant, and besides, applied to oil would generate a net cost of 45% and (coal was 240%)! Slate notes that Pimental calculates gas as being a benefit of 527%, so they disagree profoundly on a very basic fact. Dale seems wrong intuitively because it can't cost more energy to generate oil and coal because otherwise we wouldn't have any oil and coal--if we lose more of it trying to get it we wouldn't have as much as we do--where does the energy then come from?

The debate seemed at an impasse of technical details, but I think we have a definitive answer. Recent research suggests it would be more efficient to actually burn the corn, rather than process it and use it as fuel. From Bloomberg:

Burning sugar cane or corn to make electricity for powering cars may be smarter than refining the crops into biofuels.

Clearly we are defining biofuels down if they are now best used like dung in some African village. By the transitive property, if burning corn is better than turning it into ethanol and burning it, oil or gas is more efficient than ethanol.

The new DOE chief, Nobel prize winning scientist Steven Chu has noted that ethanol is probably not the way to go. Too bad we put in this massive infrastructure to process corn as a fuel, including multi-year mandates, subsidies and tax credits. One big problem with government solutions, is that like the education quagmire, the solution is always more money.

If you participate in the Treasury's plan to buy troubled bank assets with Treasury funding, TARP Oversight Panel chairman Elizabeth Warren suggests they should face unspecificed oversight. "If you want to take taxpayer dollars, you cannot conduct business as usual," said Warren. She implied that participating in this plan is basically receiving taxpayer dollars. CNBC tried to pin her down as to what this would mean, and she was very careful not to say anything specific, just to leave the door open.

Clearly, investing in the Treasury's PPIP in that context invites a lot of 'operational risk'. I don't know why a large hedge fund would risk such an entanglement.

Sunday, May 10, 2009

It's a dirty little secret that banks make a lot of money on their worst credits. Bad credits tend to be desperate or cognitively challenged, making them good customers. But there is competition for these saps, and banks are profit maximizing, so they set prices such that the spread, loss, and volume is optimized. Thus, one can expect any regulation that caps prices to lower volume and profits.

Congress and the President are hot to get some good PR by limiting the ability of credit card companies to add fees and whatnot. Minor stuff in the scheme of things. Here in Minnesota, there is a proposed 30% corporate surcharge on all revenue from interest rates over 15%. That sounds like a nightmare to administer, and I don't know if that means they follow the profits of all payments from individuals to their various companies around the globe, just apply it to Minnesota based companies, or how they plan to determine earnings on a single line of business within a large diverse financial organization (it's a surcharge on earnings, not revenue). Hey, it's popular, worry about details later. But all this will do is lower the amount of credit extended to these people, and probably raise their overall lending costs. If you think their spending is like buying cigarettes, that's a good thing. I'm actually quite shocked by the amount of debt most poor people have, and think they would be wise to borrow less.

In sum, it does not amount to much, but protecting people from themselves is never easy. There are alternatives, and if credit card debt becomes overly regulated, then pay-day loans, or rent-to-own, will gain market share, and it's not clear the poor win. The bottom line is that it is hard to protect someone from their own poor judgment, and it just gets harder the further away one gets from the person. Credit is fungible, coming in various conditions and services. Unfortunately, regulations to protect consumers tends to merely overwhelm them with information. For instance, even in 2006 during the height of the mortgages lending bubble, a mortgage document would take about 15 different initials on various pages of 10 point font documentation that borrowers did not read. Anything that aims on informing desperate or stupid people on how much they are paying should focus more on prioritization of information disclosure, not the absolute amount. Investment professionals would benefit from greater disclosure about financial balance sheets, because there are relatively few analysts but they have the ability and willingness to check this out. You average borrower's eyes glaze over when faced with page and page of disclosures. Know your audience, legislators.

Saturday, May 09, 2009

The Perimeter Institute sponsored a conference on how non-economic scientists and mathematicians can address the recent economic crisis. As we all know, economists did not forecast this crisis. Non-economists, those outside the sway of convention economic dogma, saw it a mile away. Where have these models been? A clue was provided by one Eric Weinstein in a panel discussion:

I've more or less tried to keep a low profile the best I can, for the last 20 years, because it hasn't been a very safe environment to talk. And finally, we have in the United States at least, a President who openly calls for nonbelievers to be brought into the big tent...we are at the beginning a hopeful period perhaps...We have been through a generation of a very low intensity sort of McCarthy era were instead of the House Un-American Committee ... we have had Fox News, we've had Lee Atwater, it's been very intimidating to talk, things have changed...

The idea, I guess, is that our economy was run by some sinister cabal, and now with The Chosen One in charge, we don't have to fear jack-booted thugs that previously impeded financial reform and intellectual progresss. I guess a lot of good ideas were kept in the closet because of frequent Bush/FoxNews intellectual waterboarding.

This was at the Perimeter Institute, a Canadian group of physicists, that at this conference to create a Manhattan Project for economics. Interestingly, Nassim Taleb was there, effusively praising the audience, even though he harshly criticizes scientism and excessive mathematics, the modus operandi of the Perimeter Institute. So if the charlatans and idiots who mistake the map for the territory do not include Andy Lo, Emmanuel Derman, Paul Wilmott, physicists doing economics, or Danny Kahneman, it's not clear what group of those doing economics he is talking about. These guys span the gamut of ways to address economics, and are hardly minority views. If these guys get a pass, I don't see who doesn't.

Taleb's schtick is merely to harshly criticize 'conventional wisdom' as practiced by those outside his listening audience, flattering his listeners that those morons don't get it like 'we' do. Though I find this very dubious reasoning, clearly his popularity as a speaker and writer suggest this is an effective rhetorical device. If you are well-known and say nice things about Taleb, he'll exempt you from his list of idiots and praise you. If you criticize the significance of what Taleb is saying, he'll call you an idiot (or, if you don't have a Nobel prize, just threaten to sue you, write your boss to get you to stop saying mean things, etc.).

Taleb mentioned some guy who said an event that should have happened once every 10 thousand years happened three days in a row. Clearly, this guy is describing a bad model, and if he really meant it, he is not very smart. I don't see how damning this is for economics, because most good economists I know recognize that financial time series have fat tails. But, when people pay $50k a speech, they expect to hear revolutionary ideas, and without straw men the ideas seem much less revolutionary. The idea that if you take a time series with fat tails, and process it with a very nonlinear function, it will be very hard to predict the outcome, is rather obvious. OLS, variance, are all meaningless. I don't get it. What is the alternative, extreme value theory? Chaos theory? For many things, you get similar results, because variance is correlated with extremum, and for many other applications the standard errors are so large and non-robust to small changes in parameters you can't use these models. On the other hand, like Winston Smith in 1984 I have been intellectually waterboarded so much, I'm incapable of seeing why this observation is so revolutionary (plus, I'm on the Haliburton payroll).

If you knew which banks were going to be given the increased capital requirements before the close yesterday, it would have probably hurt you. That is, banks under review are up about 7%, but Fifth Third is up 50%, and it was in the 'bad' half (it needs to book capital by 23% of current market cap).

Thursday, May 07, 2009

Well, the Treasury announced their stress test results, and the adverse events they are guarding against aren't absurd. For example, average credit card charge-offs are 5% a year. The baseline case is 6-8%, and the adverse 9-10%. Consumer loans don't move as much in bad times, and I haven't heard of aggregate credit card charge offs that high, but if the Roubini scenario arises, I guess it's possible. C&I loans they think might rise to 4% (annualized), which is a reasonable worst case scenario. And so on down the line.

Simon Johnson (who was interviewed today by 5 different national news outlets for the same money quotes) and other doomsters think this is all capture by the banks, that we should nationalize asap and put someone more public minded on their boards, like Franklin Raines or Jamie Gorelick. Looking to the ex-Chief Economist at the IMF for advice on financial markets is like asking Ronald McDonald for advice on a good menu--the guy was a PR prop. The IMF are a bunch of top-down do-gooders with a horrible track record. His current credibility comes from first his position at MIT, and then journalists thinking that businessmen actually listen to the chief economists of aid groups like the IMF. I hope they realize that the FCC and other regulator bodies that cover journalists have economists. I'm sure they have no clue, or care, what these people think.

But what is the relationship between capital and risk? It makes sense if you assume that capital is a cushion for losses on a static portfolio. But banks do not have static portfolios, they have franchises, with a lot of turnover and brandvalue. A bad analogy is at the bottom of all bad ideas, and the bad analogy here is that a bank is closed-end portfolio of rated securities. It's a franchise, with brand value, and most of its present value is from assets currently not on the books.

Look at the relationship between equity volatility and the capital to risk-weight asset ratio above for the banks under review. There should be a negative relatioship between the cushion (capital/risk weighted assets), and volatility. There is, but the R2 is 0.06, meaning, the relationship is insignificant (note: using implied volatilities gives the same result). So, the market does not see a strong correlation between capital-to-assets and risk, but for the Treasury, that is all that matters. This highlights that what is measured (capital to assets) is what is managed by super senior management, no matter how irrelevant.

Note the key to this crisis was the erosion of mortgage underwriting standards that occurred prior to 2008. Did regulators ever mention this, except when encouraging them? Thus, like macroeconomics, the keys are incentives that are decentralized and parochial to a small niche (big banks have literally hundreds of different businesses with different underwriting criteria and expected losses), but top-down diktats can only address big things like 'total capital to assets', and so the focus. This highlights the random nature of Federal regulation.

This seems insanely misguided, top-down, attempt to do something. Note that the capital add is much more correlated with the current estimated earnings per share over price:So, the capital add is consisttent with current estimates of this quarter's losses, more than anything else, which I guess makes it less hurtful (correlation go down significantly for subsequent periods).

I would prefer that they merely apply this exercise, disclose the results, and let the market render their verdict. Everything gets complicated when government has to micromanage something they are dilettantes in. It would be nice if banks had to disclose greater particularity about the nature of their assets and liabilities. Regulations can be good, and made better. But this exercise is like the Homeland Security Advisory System, the appearance of doing something useful, thinking that 90% of risk management is in appearances.

I would say most of my friends are socially liberal and fiscally conservative. In a word, libertarians. We like the right to use guns and drugs, and have sex in any consenting adult manner we please. But we also don't like taxes, and redistribution schemes like welfare and social security. Nevertheless, the major party divide in the US are social liberals/high taxers in one party, social conservative/low taxers on the other. Why is this the default when it seems so schizophrenic?

I think Arnold Schwarzenegger gives us a hint, as he recently broached the idea of legalizing marijuana. This has the obvious appeal to social liberals who believe in freedom to make such decisions for ourselves. But as California is in a huge structural budget deficit and has little ability to address spending, the need for cash to sustain the Beast is the real driver. As The Terminator notes: 'I think all of those ideas of creating extra revenues, I'm always for an open debate on it.'

Before the modern personal income tax in 1913, liquor taxes accounted for about a third of federal revenues. Then came the income tax in 1914 and, on its heels, America’s entry into World War I. During the war federal revenues received through income taxation for the first time exceeded those from any other single source. By fall of 1917 Congress saw the income tax as its chief source of revenue, reducing the cost of voting for Prohibition in December 1917.

The Great Depression severely depressed incomes and tax revenues correspondingly plunged beginning in 1931. By 1932 federal income-tax receipts fell by well over a third from their level in 1931 and to almost half their 1930 level. Prohibition’s repeal in 1933 generated a big jump in revenues. As a percentage of federal government revenues, liquor taxes jumped from 2 percent in 1933 to 9 percent in 1934 to 13 percent in 1936.

Big government fans need money, and income tax revenues do face a Laffer curve effect at some rate. In this context, taxing underground activities is a no-brainer for most Liberals, and so big-government types are in favor of legalizing activities that conservatives think are best kept underground. It's not a complete theory, but I think it explains some of our strange two-party idealogical cleavage.

Wednesday, May 06, 2009

Tyler Cowen and Alex Tabarrok have a new Macro textbook, and it sounds awesome. It actually prioritizes incentives. Incentives-based approaches basically apply the assumption of individual self-interest and looks at the implications. That's Adam Smith's insight, and he's the father of economics. The father of macroeconomics has not generated similarly fruitful insights. Since Keynes macro has focused on aggregate accounts and indices, operating according to laws of motion. Sure, you might motivate the laws via a consumer maximizing his lifetime income, but that's all throat clearing for estimating equations where aggregate amounts C, G, I, and X interact with monetary variables P, i, and M in some dynamic feedback loop

The hope was that macroeconomics would be like physics, where you have laws at a lower level, and unrelated laws at a higher level. In 1972, Philip Anderson, who won the Nobel prize in physics for his work on superconductivity, wrote an article titled “More Is Different,” and contended that particle physics, and indeed all reductionist approaches, have limited ability to explain the world. Reality has a hierarchical structure, but that does not mean one should always try to explain one layer from deeper layers.

At each stage entirely new laws, concepts, and generalizations are necessary, requiring inspiration and creativity to just as great a degree as in the previous one. Psychology is not applied biology, nor is biology applied chemistry.

No collective organizational phenomenon, such as crystallization and magnetism, has ever been deduced from its lower-level parts. Emergent phenomenona render reductionist views irrelevant for explaining phenomena at that level—it is unhelpful to try to understand cancer through mere chemistry, or worse, particle physics. But that does not mean that chemistry, or particle physics, is uninteresting, just, at one level, not so much.

Unfortunately, macro economics has not generated comparable emergent properties in macroeconomic time series. Incentive matter a great deal on the macro level, even if they are more difficult to reify than something like total consumption or the money supply. The stagnation of socialist economies was not predicted by 1950's economists, indeed most economist thought capitalism was merely superior in liberty, not growth or prosperity. The thought the economy was like a big input-output matrix, and with centralized planning combined with forced savings, the Soviet Economy seemed sure to overtake the West. But this turned out quite wrong because people in a position to make decisions did not have the right incentives. I don't know exactly how Cowen and Tabarrok handle this in their text, but a good assumption goes a long way, and moving from textbooks with price-stickiness models, or government multipliers, to starting with incentives, is a first-order step in a better direction.

They mentioned they address the current financial crisis, and though I'm sure there's a demand, with so much new information coming out, and the fate--if not the current condition--of banks so uncertain, I sense that section will be much rewritten if there is a second edition. In any case, mazel tov, gentlemen!

In the Chrysler deal, the [United Auto Workers] were unsecured creditors and the Chrysler bondholders were secured creditors. The bondholders received 28% of the value of their $6.9 billion in bonds in cash; the Union will receive stock worth approximately $4.2 billion, and a note for an additional $4.58 billion, which represents 82% of the value of their claim. Either the government negotiators have dyslexia and have made a terrible mistake in their paperwork, or this is political payoff writ large. Is this not the equivalent of financial waterboarding?

The President screaming that the hedge funds are looking for an unjustified taxpayer-funded bailout is the big lie writ large. Find me a hedge fund that has been bailed out. Find me a hedge fund, even a failed one, that has asked for one. In fact, it was only because hedge funds have not taken government funds that they could stand up to this bullying. The TARP recipients had no choice but to go along

Law is an interesting subject. The letter, intent, and popularity of the law, all interact in a game with a great deal of strategy. Having been involved in costly litigation, I know the game is anything but straightforward, because if you try to be reasonable in a game with someone who has bad faith, you will lose even more (most litigation involves loss for both parties, it's just damage control once you start). Further, the end-game is hardly limited to what some jury decides, because of the precedent, judge's decisions, the signaling, the costs, and the fact that most disputes do not go to trial.

While this gaming is all unavoidable in a world with people, it is disturbing when something as solid as liability law and throws it out the window (debts used to have an explicit priority).

Tuesday, May 05, 2009

Nouriel Roubini called the recent crisis, and for this his status as a prognosticator has elevated. But his call has been perenial, and the driver anything and everything. In today's Wall Street Journal, Roubini outlines how he would address the crisis, and He outlines regulations he has in mind, including the following:

Consider also recent bank risk-taking. The media has recently reported that Citigroup and Bank of America were buying up some of the AAA-tranches of nonprime mortgage-backed securities. Didn't the government provide insurance on portfolios of $300 billion and $118 billion on the very same stuff for Citi and BofA this past year? These securities are at the heart of the financial crisis and the core of the PPIP. If true, this is egregious behavior -- and it's incredible that there are no restrictions against it.

Typical risk manager, looking in the rear view mirror. An AAA mortgage now is not like a AAA mortgage in 2007. Mortgages have been tanking for 18 months. They experienced historic losses in that time. So, using the same logic that got us in this mess, assumes that these assets, regardless of current quality (mortgages are a heterogeneous lot), all mortgages are now ultra risky.

As the rating agencies are especially wary about mortgages, any specific AAA rated mortgage security is probably the least risky AAA security out there. The incentives for doing this are all skewed in favor of being too pessimistic. Historically, the best ABS investments have been in areas with above average defaults in the recent cycle. I don't think commercial real estate mortgage backed securities (CMBS) had any losses from 1992 to 2000, as the rating agencies overcompensated. Thus, if the rating agencies are specifying some mortgage backed securities as AAA, I bet they are pretty safe.

But, using the reasoning that those assets that 'got us into this mess' are now ALL bad, he suggests micromanaging the banks to exclude such assets going forward. It's all too typical, and exactly the kind of stupid extrapolation that led investors to believe that ALL mortgages were safe simply because they had historically low losses. Details matter. For mortgages, the fact that so many were becoming no-documentation, teaser rate, high LTV loans, was significant, but those are details. For current mortgages, ignoring these details on mortgages is equally an error, even if in the other direction. Pushing banks into other 'regulator approved' safe assets was also a cause of this crisis, and we shouldn't do that again. Regulators, or academics who never worked for a bank, are not forward looking.

The risk management group Moodys/KMV has a proprietary default model of public companies with several tricky refinements that it swears is significantly more powerful than simple applications of the Merton model. I have a model, Defprob, that I think does as well as the Moody's model, as it basically uses a Merton model in conjunction with a handful of obvious supplementary inputs. But in any case, I was reacquainted with this strange elevation of useless nuance via the following observation in Geoffrey Miller's new evolutionary biology book, Spent:

Is it an accident that researchers at the most expensive, elite, IQ-screening universities tend to be most skeptical of IQ tests? I think not. Universities offer a costly, slow, unreliable intelligence-indicating product that competes directly with cheap, fast, more-reliable IQ tests. They are now in the business of educational credentialism. Harvard and Yale sell nicely printed sheets of paper called degrees that cost about $160,000 ($40,000 for tuition, room, board, and books per year for four years). To obtain the degree, one must demonstrate a decent level of conscientiousness, emotional stability, and openness in one’s coursework, but above all, one must have the intelligence to get admitted, based on SAT scores and high school grades. Thus, the Harvard degree is basically an IQ guarantee.

So basically, those selling costly substitutes for a simple rule are the most vociferous in blasting the simple rule. You could have a simple 'seal of approval' based on some g-loaded test (eg, the SAT> 1300), and some objective extracurricular accompishments to show you aren't a socially obtuse nerd. Throw in passing some on-line courses in physics, computing, English, and statistics, and boom: everyone can be confident you are a great bet as a new hire.

An honest expert admits when a simple alternative does as well as a sophisticated model or analysis. Alas, most experts are not honest, at least not publicly. They aren't evil, they just convince themselves that their years of expertise imply the entire gestalt is necessary to capture the situation, as if the fourth and seventh elements of a power series are essential in a power series approximation, and naive approaches merely look at the first two terms. The cognitive dissonance needed to believe these self-serving confabulations is something most experts accept as life in the real world, like a politician talking about the public at large while merely handing out jobs and contracts to his voting base--everyone has their axe to grind. As Holden Caulfield noted, most adults are phonies in some way, you just have to learn to deal with it.

Anyone currently in a good position due to more convoluted signalling will pooh-pooh simple solutions, no matter how near-optimal. I remember monitoring our traders as a risk manager, and invariably a market maker would present himself as a savvy speculator, with great insights as to short term movements and longer term trends (these always are in opposite direction, so that way whatever happens falls to plan). Thus, if you said, 'all you do is buy stuff from retail goobs below the bid and sell above the ask, and make riskless profit', you would never be in the circle of trust. Some things on the trade floor, known by everyone, are never stated openly, because phone clerks don't get paid $200k+, while 'traders' do. But it was similar in the Asset and Liability Committee (ALCO) meetings, where you have a bunch of people picking a point in duration space, and smoothing earnings by selectively buying or selling something in the 'banking book' which generates an immediate hit to the pnl even though its value was known for many moons. Such a task could be automated, but then the naked interest rate bets, earning manipulation, would be too transparent. So the ALCO's purpose was to manage earnings, and take interest rate bets, in the most convoluted way possible using all the latest financial jargon: "we are seeking greater liability sensitivity in the current uncertain environment that suggests we synergistically position ourselves to maximize the risk sensitivity..."

Back to credit models, in KMV's case, Shumway and Bharath show that one can simplify the Merton model further, and approximate the Merton approach fairly well. I too find their rule works relatively well.

KMV can always point to their proprietary default database, and as it is proprietary, you can't prove them wrong, though such a database is not nearly as special as they think (these are public firms, after all). I'm 97% sure their model does not significantly outperform a naive Merton Model, and that adding their liability adjustment, or their adjustment to historical volatility by looking at how the liability structure has changed, doesn't add up to anything significant. There is value to having a popular risk measure, however flawed, because it makes communication easier across parochial domains--there are economies of scale in validation and transparency--but that's not a very compelling sales pitch because then you don't have barriers to entry that would protect intangible assets. So the equilibrium tendency is to complicate things more than they should be, and highlight irrelevant nuances and vague principles, because then no one can copy you.

This is all unfortunate because it takes something relatively simple--the default modeling problem has a 'flat maximum'--and makes it seem much more complicated than it really is. It would be nice if valuable analytics or signals were knife-edged and involved subtle nuance, because that implies knowledge is not just 'good', but valuable. For instance, what if dynamic programming generated clearly superior fiscal policy? Or if 2-stage least squares was really more useful than ordinary least squares? The Wald, Likelihood ratio, and Lagrange Multiplier statastical tests all necessary and complimentary? Then, all that hard work, that extensive, difficult to emulate knowledge would be worth quite a bit.

Truly good ideas are pretty robust and involve a handful of parochial, but straightforward adjustments. It helps to know the fancy math extensions to be sure of this, and often it takes an advanced knowledge to apply simple principles well, but the bottom line is an optimal solution that is not very 'sophisticated'. No one wants to hear this, because if you educate yourself sufficiently to understand the problem well enough to actually know if this is true in any specific case you have a vested interest in having a complicated solution.

Friday, May 01, 2009

Geithner was to release the results of the stress test Monday, but Geithner pushed it back to Thursday. The WSJ notes there are objections from some banks:

The results were pushed back several days as federal regulators and the banks have continued to debate the results. Several banks, including Bank of America Corp. and Citigroup Inc., have challenged the government's findings.

The results are expected to show that several banks may need more capital, or a higher quality of capital, in order to continue lending if the economy worsens through 2010.

You see, if the Government says that the sensitivity of mortgage portfolio to a 13% unemployment rate and 20% house price fall is to lose 30% of its value, the banks say 10%, the data will be inconclusive. The standard errors to this hypothetical are too large. Lots of details matter: loan-to-value, fico scores, loan vintage--and these interact in various ways, and as home prices have not fallen a lot historically, you have very few observations to generate an empirical estimate of a multivariate relationship. Thus, if the Treasury does force their stress tests through, and equity investors lose 50% of their value, I smell lawsuit. Remember that in the S&L crisis, many bank recovered billions as courts found the government's redefinition as to what counts as capital, sufficient for a bank to be a going concern, was not justified.